Temporary and proposed hedging regulations.

• Position: Tax Executives Institute Federal Tax Committee

On February 4, 1994, Tax Executives Institute submitted the following comments on the temporary and proposed regulations relating to business hedging. The temporary and proposed regulations were issued under sections 1221 and 446 in response to both the Tax Court's decision in Federal National Mortgage Association v. Commissioner (Fannie Mae) and the congressional directive to the Treasury Department that the Treasury and IRS study the tax issues arising from the United States Supreme Court decision in Arkansas Best v. Commissioner. TEI's comments were prepared under the aegis of its Federal Tax Committee whose chair is Michael A. DeLuca of Household International Corporation. Contributing to the development of TEI's comments were Donald N. Adler of Dean Witter / Discover Co., Philip G. Cohen of Unilever USA Inc., Stephen P. Kaplan of Society Corp., Roger D. Wheeler and James Aretakis of General Motors, and Clement Wydra of Diamond Shamrock.

On October 18, 1993, the Internal Revenue Service issued Treasury Decision 8493,(1) promulgating temporary regulations under sections 1221, 1233, and 1234 of the Internal Revenue Code. Simultaneously, the IRS issued a notice of proposed rulemaking (FI-46-93) declaring that the text of the temporary regulations serve as proposed rules for purposes of adopting final regulations.(2) Assuming certain administrative requirements are met, the temporary and proposed regulations treat gain or loss arising from defined business "hedging transactions" as ordinary in character under section 1221. In a related action, the IRS issued a notice of proposed rulemaking under section 446 (FI-5493)3 addressing the manner and timing of recognition of gain or loss realized on hedging transactions. The temporary and proposed regulations were published in the Federal Register on October 20, 1993 (58 Fed. Reg. 54037, 54075, and 54077, respectively), and in the Internal Revenue Bulletin (1993-35 I.R.B. 16, 22, and 24, respectively) on November 8, 1993.(4) A public hearing on the regulations was held on January 19, 1993.

1. Background

   Tax Executives Institute is the principal association of business tax executives in North America. The Institute's approximately 4,700 members represent more than 2,400 of the largest companies in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the deve]opment and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and the government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply.

   TEI members are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the temporary and proposed regulations relating to the income tax treatment to be accorded to hedging transactions.

2. Overview

   For many years, transactions involving the acquisition of property by businesses to hedge against price changes of other assets and liabilities were characterized upon disposition as giving rise to ordinary income or loss. The preamble to the temporary regulations explains that the legislative history of the Internal Revenue Code of 1954 expressly notes that business hedges were accorded ordinary treatment under existing law and that Congress declared its intent to continue that treatment? Under the widely accepted interpretation of the United States Supreme Court decision in Corn Products,(6) the tax treatment of transactions entered into as business hedges depended upon the motive underlying the transaction: gains or losses were characterized as ordinary or capital in nature depending upon whether the transactions were undertaken for ordinary business or speculative investment purposes.(7) In Arkansas Best Corp. v. Commissioner,(8) however, the Supreme Court narrowed the orthodox exegesis of Corn Products, holding that a taxpayer realized a capital loss on the sale of shares of a company even though acquisition of the shares may have been motivated by business exigencies.

   In the aftermath of the Arkansas Best decision, the courts, the IRS, and taxpayers have struggled to divine the extent to which property or positions acquired in "hedging transactions" either fall within one of the enumerated statutory exceptions contained in section 1221 or are otherwise properly excluded from the definition of a capital asset. Initially, the IRS interpreted Arkansas Best restrictively to hold that only positions resulting in or possibly resulting in the acquisition of "inventory" assets qualified for ordinary treatment. This view spawned a number of disputes because the IRS challenged the accounting treatment for hedging transactions that taxpayers had considered to be well settled. In addition, disputes arose because of uncertainty concerning the proper treatment of derivative financial products for which no specific statutory or regulatory guidance exists. The proliferation of these financial products to better manage various business risks exacerbated the number, complexity, and scope of controversies between the government and taxpayers.

   In Federal National Mortgage Ass'n v. Commissioner (Fannie Mae),(9) the Tax Court rejected the IRS's narrow interpretation of the treatment of business hedges, concluding that the various transactions undertaken in that case were integrally related to the taxpayer's business of buying and selling mortgages and that the character of the hedge transactions should match the ordinary gain or loss treatment accorded the hedged property. Following on the heels of the Fannie Mae decision, Congress--in the Conference Report to the Omnibus Budget Reconciliation Act of 1993--directed the Treasury Department to study the tax treatment of hedging transactions and report its findings and recommendations to the congressional tax writing committees. In response to the congressional directive and the Fannie Mae decision (as well as the underlying uncertainty created by Arkansas Best), the IRS issued the temporary and proposed regulations.(18)

   TEI commends the Treasury and IRS for responding to the need for guidance on the income tax treatment of business hedging transactions. The widespread use of derivative financial products and the complexity of the tax law on matching of character and timing of income or loss for business hedges has engendered far too much controversy to be resolved through a case-by-case examination and litigation approach. The muchneeded guidance will bring certainty to the treatment of many routine transactions and enhance compliance generally. Thus, TEI believes that the temporary and proposed regulations represent a solid cornerstone upon which comprehensive guidance on the tax treatment of hedges and derivative financial products can be erected.

   We regret, however, that the regulations are flawed in certain respects. By failing to address important issues, adopting positions that conflict with economic or practical business realities, and encumbering taxpayers with excessive administrative requirements, the regulations threaten to impede efficient risk-management practices and leave the door open for substantial continuing controversy between taxpayers and the government. We believe that the comments and recommendations that follow effectively address these flaws and will enable the IRS to improve its framework.

3. Definitions of Key Terms

   Temp. Reg.[sections]1.1221-2T(a)(1) excludes from the definition of "capital asset" any property that is part of a "hedging transaction." Temp. Reg.[sections] 1.1221-2T(b)(1) defines "hedging transactions" as transactions entered into in the normal course of the taxpayer's trade or business primarily to reduce the risk of either (i) price or currency changes with respect to "ordinary property" held or to be held by the taxpayer or (ii) interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer. Temp. Reg.[sections] 1.1221-2T(b)(2) in turn defines "ordinary property" as any property the sale or exchange of which could not produce capital gain or loss regardless of the taxpayer's holding period at the time of its sale or exchange. Similarly, "ordinary obligation" is an obligation the performance or termination of which by the taxpayer could not produce capital gain.or loss. The net effect of the rules is to characterize the gain or loss on dispositions of certain property as ordinary rather than capital.

   1. Definition of Hedging

      Transaction Too Narrow

      The definition of a "hedging transaction" is drawn from section 1256(e) of the Code,(11) which posits an exception to the general mark-to-market timing rule of section 1256(a) for "hedges." The legislative history of section 1256 makes abundantly clear the prevailing understanding among Congress, Treasury, and tax practitioners that "business hedges" are generally ordinary in character and that transactions involving hedges were not the target of the section 1256 rules. Also, Congress clearly stated that it did not intend for the section 1256 rules to curtail the use of futures transactions for commercial hedging purposes.(2) In other words, section 1256 was enacted to provide clear timing rules to prevent perceived abuses involving tax straddles by professional commodity traders. The business hedge exception in 1256(e) should not be viewed as a limit on the Treasury's authority to clarify the treatment of the character of hedges, nor should the Treasury adopt a...